When workers' search efforts are unobservable, the provision of insurance against firm-specific shocks adversely affects their incentives to find better jobs. In consequence, the equilibrium contract prescribes low wages and underemployment to encourage workers to leave low-productivity firms; and it employs both quits and layoffs to induce separations, with the mix depending both on the relative efficiency of on- and off-the-job search and on the search-incentive effects of layoffs.